Question

Proposal #1 would extend trade credit to some customers that previously have been denied credit because they were considered poor risks.   Sales are projected to increase by $240,000 per year if credit is extended to these new customers. Of the new accounts receivable generated, 6% are projected to be uncollectible. Additional collection costs are projected to be 2% of incremental sales (whether they actually end up collected or not), and production and selling costs are projected to be 78% of sales. Your firm expects to pay a total of 30% of its income after expenses in taxes.

1. Compute the incremental income after taxes that would result from these projections:

2. Compute the incremental Return on Sales if these new credit customers are accepted:

If the receivable turnover ratio is expected to be 3 to 1 and no other asset buildup is needed to serve the new customers…

3. Compute the additional investment in Accounts Receivable
4. Compute the incremental Return on New Investment

5. If your company requires a 20% Rate of Return on Investment for all proposals, do the numbers suggest that trade credit should be extended to these new customers? Explain.

Proposal #2 would establish local collection centers throughout the region to decrease the time it takes to convert credit payments that are mailed in by check to cash. It is estimated that establishing these collection centers would reduce the average collection time by 2 days.

1. If the company currently averages $50,000 in collections per day, how many dollars will this suggested cash management system free up?

2. If all freed up dollars would be used to pay down debt that has an interest rate of 6%, how much money could be saved each year in interest expense?

3. Do the numbers suggest that this new system should be implemented if its total annual cost is $8000? Explain.

Answer 1

PROPOSAL 1

1. Computation of Incremental Income after tax

Incremental sales..................(A) 240000

Less: Incremental Expenses..........(B)

bad debt expenses -14400

(240000*6%= 14400)

Additional collection cost -4800

(240000*2%=4800)

Production & selling cost -187200

(240000*78%=187200)

Incremental income (A)- (B) 33600

Less: Tax @ 30% i.e 33600*30% -10080

Incremental income after tax 23520

2. Computation of incremental return on sales

Return on sales= operating profit/ net sales

Incremental return on sales =(23520/240000)*100 = 9.8%

3. Computation of additional investment in Account Receivable

Receivable turnover ratio = Net credit sales/ average account receivable= 3:1

Net credit sales= 240000

Investement in Account receivable= 240000/3= 80000

4. Incremental return on new investment

New investment in accounts receivable =80000

Incremental return on investment= Incremental profit after tax/ Incremental investment

=(23520/80000)*100 = 29.4%

Advice : Since actual incremental rate of return i.e 29.4% is higher than required rate of return of 20%, trade credit should be extended to new customers by the entity